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Europe’s banking system would be at risk in another downturn, stress tests find

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ROME — Europe’s banking system remains heavily dependent on government support and would be at risk if another economic downturn were to hit, the European Banking Authority said Friday in a report that highlights the lingering weakness in a financial system considered integral to a stronger global recovery.

The inability of Europe to better bolster its banking system and make it less dependent on public support has been a central feature of the region’s economic troubles. It is related to the sovereign debt crisis because many banks hold the bonds of heavily indebted European countries.

But it is also a separate and, in a sense, broader problem: The financial system’s fragility holds back the economic growth that some weakened countries, such as Greece and Spain, desperately need, and it is also the pipeline through which debt problems in one nation can undermine another’s economy. Stronger banks are better able to fight off such contagion.

In the latest stress test of 91 European institutions, the European Banking Authority (EBA) found a system that would be rocked by a mild recession and a spike in unemployment rates to levels that some European nations are already experiencing. While only eight of the 91 banks failed outright — meaning that the “adverse but plausible” economic assumptions made by the authority pushed their cash and capital buffers below 5 percent of the value of the bank’s assets — another 16 barely passed.

Many of the firms were allowed to include recently raised capital; others passed the test only on the basis of roughly $200 billion in government support propping up the European system.

The outcome led the EBA, the International Monetary Fund and other European officials to call on national regulators in European countries to make sure that banks improve their balance sheets — and soon. The EBA wants capital plans in place within three months. The 91 banks covered by the study represent the bulk of Europe’s bank assets.
“The risk outlook for European banks in general is a source of concern,” Andrea Enria, the EBA chairman, said at a London news conference. “There is this lingering concern that we have not cleaned our house.”

That feeling is likely to continue as analysts noted a tension among the study’s generally positive headline findings, the text of the report and realities in Europe.

The eight failing banks were estimated to need about $4 billion in additional capital — a relatively modest amount and about the same as found in a stress test conducted a year ago. That test was widely discredited after several Irish banks promptly failed despite being given passing grades.

However, the body of the latest report was more cautious. It said a passing grade on this exam was a “necessary but not sufficient” condition for withstanding shocks that may lie ahead.

Analysts also took issue with the fact that the study, by design, excluded the possibility of a default by one or more nations — not because it is unlikely but because many of Europe’s political leaders have said they would prevent it. Analysts believe that at least one indebted country, most likely Greece, is likely to default at some point.

The test did require banks to disclose holdings of government bonds and to discount their value based on the EBA’s economic assumptions, but it stopped short of modeling a default.

“A main problem for banks is the exposure to sovereign debt, and the reason why we are not able to address the problems of Greece as an insolvent country is that it is going to provoke a major banking crisis,” said University of Rome economist Paolo Guerrieri. “The stress tests did not say anything about that. They are not reflecting the core problem.”

It will be left for market analysts to ferret out the more detailed implications of the study, which has forced banks to divulge a trove of information about their investments, including country-by-country lists of their government bond holdings.

That firm-by-firm breakdown will shape market sentiment in coming days as analysts look at which banks are most dependent on the government, which have the largest holdings of sovereign debt and which are most vulnerable, said Francis Fitzherbert-Brockholes, a capital markets specialist with the law firm White & Case.

It may also allow outside analysts to do what the EBA did not — estimate the fallout from a sovereign default. With three European countries under IMF rescue programs, European government bonds are no longer considered to be the safe havens they were when banks bought tens of billions of dollars’ worth as investments that could easily be used as collateral for other loans.

Greek bonds are now trading for as little as 50 cents on the dollar, and talks are underway about a formal reduction in their value as a way to help Greece’s economy revive — a step that bond-rating agencies say would prompt them to declare a default.

The European Central Bank fears the worst, arguing that a default in one country would put all 17 euro-zone nations under a cloud and possibly trigger a global credit crisis. Others say Greece needs debt relief and that it could be handled without causing larger problems — a theory that analysts may be able to test now that they know the sovereign debt holdings of major banks.

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